In 2012, the United States Court of Appeals for the Third Circuit, reversing the Tax Court, found that an investor in an historic rehabilitation project was not entitled to claim historic rehabilitation tax credits because the investor could not be regarded, for tax purposes, as a bona fide partner of the developer in the purported partnership. Historic Boardwalk Hall, LLC v. Commissioner, 694 F.2d 425 (3d Cir. 2012), cert. denied, 133 S.Ct. 2734 (2013). Applying a "substance over form” analysis, the Court found that the investor should not be treated as a partner in a partnership because the investment was not subject to any meaningful business risk and lacked any potential upside for profit in the venture. The investor, therefore, could not be viewed as participating in the business of the partnership. Certain elements of the transaction eliminated all downside risk: (i) the timing of the investor contributions, which occurred only after the tax benefits were assured, (ii) guaranties by the developer of the project that ensured the investor would receive the value of the anticipated tax benefits, and (iii) a fully defeased put option held by the investor. In addition, a call option held by the developer effectively limited the investor’s upside potential to the amount of its preferred return. The Court thus concluded that, because the Internal Revenue Code permits these credits to be claimed only by genuine partners, the investor could not claim them.

The Historic Boardwalk Hall case raised substantial concern in the development community. In response, the Internal Revenue Service promised to issue guidance and, on December 30, 2013, finally issued Revenue Procedure 2014-12, 2014-3 I.R.B.1. The IRS further revised the Revenue Procedure on January 9, 2014. The revenue procedure establishes a "safe harbor” under which the Internal Revenue Service will not challenge allocations of historic rehabilitation tax credits by a partnership (including an LLC taxed as a partnership) to its partners on or after December 30, 2013.

The key aspects of the safe harbor include:

The principal (the general partner of a limited partnership or manager of an LLC) must have a minimum one percent interest in each item of income, deduction or credit. Until now, in many transactions, the developer’s interest was substantially less than 1%.

The investor at all times must have a percentage interest in items of income, loss, credit, etc., that is never less than 5% of its highest percentage interest. The Revenue Procedure illustrates the rule in an example: if the investor holds a 99% interest when it receives an allocation of credits, but after the 5-year historic credit recapture period its share of income and loss items falls to 5.0%—sometimes referred to as a "flip”—the "flip” in percentage of ownership from 99% to 5.0% meets the safe harbor.

The investor must participate in partnership profits and losses; a preferred return alone will not meet the safe harbor. Implicitly, the investor may have a preferred return if it also has some common interest, but the Revenue Procedure is not explicit on this point. Moreover, the investor’s interest must be a bona fide equity interest with a "reasonably anticipated value commensurate with Investor’s overall percentage in the partnership” separate from any tax attributes to be allocated to the investor.

The safe harbor also contemplates the so-called master tenant structure where the credits are passed-through to the master tenant entity (typically owned by the investors). A number of special rules apply, including a rule that the investor may not also have a direct investment in the owner/landlord (with exceptions for low-income housing tax credits and new markets tax credits) and a prohibition on the master tenant subleasing the building back to the owner/developer (with an exception for a sublease mandated by an unrelated third party lender).

The value of the investor’s interest (a) cannot be artificially reduced by fees, lease terms or arrangements that are unreasonable when compared to similar real estate projects not using historic tax credits, and (b) cannot be reduced by disproportionate distribution rights or by issuances of interests in the partnership for less than fair market value. This provision may require the developer to research and conform its agreements to current market practice. One area that likely will receive scrutiny is the size of deferred developer fees.

The investor must contribute at least 20% of its overall anticipated investment before the project is placed in service. Contributions of promissory notes are disregarded in determining whether this requirement is met. Also, at least 75% of the investor’s contribution cannot be contingent.

The developer or owner may provide only certain guaranties, which must be unfunded. Permitted guaranties include guaranties that the developer or owner will not cause a recapture event, completion guaranties, operating deficit guaranties, environmental indemnities and financial covenants. A guaranty of the investor’s tax credit, or a guaranty to make an equivalent cash payment, or guaranteed repayment of the investment because of a failure to be able to claim the credit after a challenge by the IRS, are not permissible. Further, a developer partnership or master tenant partnership (or a principal of either) may not lend money to the investor to acquire any part of its interest or provide security for indebtedness incurred or created in connection with the acquisition of the investor’s interest.

Traditionally, investors and developers have used an exit strategy for the investor that consisted of granting the investor an option to sell its interest to the developer or related party ("put option”) and, if the put option were not exercised, granting the developer an option to purchase the investor’s interest ("call option”), typically at fair market value after taking into account all fees and other payments. The Revenue Procedure dramatically changes this structure.

First, the Revenue Procedure prohibits any call option. While a put option is permissible, the Revenue Procedure provides that the put option cannot be exercisable for more than the fair market value of the investor’s interest. In determining fair market value, certain terms cannot be taken into account, including obligations or rights that are unreasonable as compared to the terms of a real estate development project not involving rehabilitation tax credits, disproportionate distribution rights, or rights to acquire an interest for less than fair market value. Thus, fees or other non-market arrangements intended to depress value cannot be used. Finally, the investor cannot intend to abandon its interest. Presumably, in determining the fair market value of the investor’s interest, a flip in membership percentages can be taken into account. The revenue procedure, however, while including two examples, including one with a flip, does not describe the effect of the flip on determining fair market value.

Although the Revenue Procedure does not preclude a below fair market value put price, the example in the Revenue Procedure involves a put at fair market value. Precluding taking into account non-market arrangements would seem to have no practical effect if below fair market value put options are permissible. It appears that the IRS was more concerned with precluding the investor from obtaining a guaranteed return—a chief concern of the IRS and the Third Circuit in Historic Boardwalk Hall—than in preventing puts that may be advantageous to the developer. Nonetheless, until the IRS issues further clarification, participants should consider very carefully how to price put options.

The Revenue Procedure is only a safe harbor; it is not affirmative law. Moreover, as the IRS emphasizes, all other requirements of Section 47 of the Code must still be met.

The guidance clarifies the conditions under which the IRS will not challenge the structure of an historic rehabilitation tax credit investment, and by its terms does not apply in any other contexts. The guidance is not clear in many respects and may require further amplification. As such, the guidance may cause some investors to leave the market or adjust the prices of their investment. In all events, investors and developers almost certainly will take the guidance into account in structuring future transactions.

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